Profit by using discipline to make better decisions
How you think and feel influences your judgement. Your judgement in turn impacts which investments you select. More often than not, emotional decisions or those based on poor logic tend to hurt portfolio performance.
We’ll begin by taking a closer look at some emotional and cognitive factors that lead to poor investment decisions.
Then we’ll show you how you can use a disciplined investment method to make better decisions and hopefully make you more money through time.
Impatient investors rarely give any investment or strategy enough time to perform adequately. And if the investment or strategy should experience a period of weakness, they end up retreating to cash. The more patient investor, on the other hand, hangs onto or even adds to a quality investment or strategy, which typically ends up building greater wealth.
Impatience might also emerge because of unrealistic expectations. Do you expect to never have a down quarter or a down year? Do you expect you’ll never have to suffer a loss?
If long term returns from stocks is expected to be around 12% and 5% for bonds, then a portfolio with 60% equities and 40% bonds is expected to return about 9.2% over the long term. One might be able to do better than this based upon the strategies that one uses; however, a return of 15%+ over the long term might not be possible without taking on a high level of risk.
Greed / Envy
In seeking large returns, some people will invest significant amounts of money in a small number of stocks. By doing so, they take on a very high level of risk. Sometimes taking the added risk pays off, but more often than not one would have been better off sticking to a diversified investment portfolio.
Don’t forget that not every investment your friend brags about at a party will double. Most speculators will have lost money than made money when you look at their entire investment experience.
The question to ask is when all your friend’s investments are taken together as a whole, would they have been better off with a balanced portfolio? Even if they as a whole did make money, was it just dumb luck?
If you are saving for your retirement, does it make sense to gamble your hard-earned money by subjecting it to high levels of risk?
Many people are too risk averse sitting with most of their wealth in cash, money market funds, bonds and other similar low-risk, low-return securities. Such people are likely to realize, probably too late, that they have shortchanged themselves, forfeiting the retirement they could have had in order to gain illusive short-term security. And they will have squandered their greatest asset – time.
There may be times when one feels it important to avoid having one’s portfolio take a beating in the market. But that risk is tiny compared with the gains you are likely to give up by avoiding the stock market. Remember that few investors are consistently successful in market timing.
Sentimentality – “falling in love with a stock”
Some people that buy an investment will continue to hold onto it because they like the product or business model even though its fundamentals have deteriorated.
It is for this reason that we recommend every investor in individual stocks have a “sell criteria” established before the stock purchase is made.
Decisions based on poor logic
Bad investment decisions might result in poor performance because too much risk was taken on. This could happen due to one erring by overweighing or underweighing the probability of each of the possible outcomes – in other words, one makes a biased decision based on their own preferences or on how the information is presented, or one errs by being overconfident in their ability to assess each of the outcomes.
Given that how we think and feel affects our decisions, one way to help make better decisions is by using a disciplined investment approach as to how much in equities over time.
Setting and sticking to an equity target
When Janet (not her real name) became a client of ours four years ago, we spent considerable time working with her to determine and set an appropriate equity target – one that would get her the growth she needed to meet her retirement goals without subjecting her portfolio to significant portfolio fluctuations.
Keeping to an equity target works when markets fluctuate. During bad times, it helps you to “buy low” and in good times helps you to “sell high”.
So, if Janet’s equities drop in value, her equities as a percentage of her overall portfolio typically drops. In keeping to her equity target, Janet is guided to sell some bonds and top up her equities to her target. In effect, when equities drop, Janet is “buying low”.
Similarly, if Janet’s equities increase in value, this typically results in equities as a percentage of her overall portfolio increasing. In keeping to her equity target, she is guided to sell some equities and buy some bonds. In effect, when equities rise, Janet is guided to “sell high”.
For Janet, sticking to an equities target benefited her over her four years as a client. But it wasn’t easy.
In 1998 and 1999 when the stock market was doing very well, Janet had found it difficult to keep cutting back her equities.
The cutting back paid off in 2000 when growth investments began to substantially drop. Janet found that having 40% in bonds moderated the overall drop in equities. Her bonds actually increased in value.
When growth investments were dropping, Janet was guided to add to equities – specifically to growth investments. She found that doing this went against her instincts.
For 2001, she experienced really good performance, much of which has to do with her bonds due to the historical drop in interest rates by the Bank of Canada and the Federal Reserve. Sticking to the discipline forced her to sell more of her bonds and add to equities. With the terrorist attack of September 11, she was forced to sell even greater amounts of her bonds and add to equities, but again it was not easy for her because of all the newspaper headlines about war and terrorism and all the layoffs being announced.
Looking back, she sees that her decisions as to reducing and increasing equities were the right thing to do and has paid off big time.
The next step
If you would like us to review your retirement plans, help you figure how much you should have in equities, and put in place the discipline to make good investment decisions, please call me. I provide Financial Planning at no extra charge to my clients. You can reach me at: (604) 288-2083 or by email at: Steve@lycosasset.com.
Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.